Rate of return is to agencies’ credit

Credit rating agencies are never out of the news. And almost every time they’re mentioned, we’re reminded that they made the worst analyst call of all time in assigning US sub-prime bonds a AAA rating.

Their role in facilitating the proliferation of bad credit up to 2008 is still fresh in the memory but now might be time to move on.

The agencies themselves haven’t looked back. This week, the two major agencies – S&P and Moody’s – released first-quarter earnings that showed the credit ratings business is thriving.

Moody’s Corporation’s 20 per cent increase in quarterly revenues to $US557 million is in range of its peak 2007 average quarterly revenue of $US564 million. The number smashed forecasts and sent its stock up 7 per cent.

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The reason the agencies are minting it again is simple: global issuance of the corporate bonds they rate has exploded. A combination of low interest rates, higher bank funding costs and a desire to raise more stable long-term debt has fuelled supply while investors seeking the safety of fixed income and the yield of corporate debt have ensured demand.

Credit ratings are a prerequisite for issuing bonds in the investment-grade, high-yield bond and leveraged loan markets. Corporate bond sales rose 22 per cent from the fourth quarter of 2010 to $426 billion globally, according to data provider Dealogic.

Even the structured finance divisions blamed for facilitating the sub-prime crisis have made solid contributions to the bottom line, as central banks have encouraged covered bonds and securitisation as a means of drip-feeding funds to their banks.

Politicians, regulators and conspiracy theorists are still baying for rating agency blood, but the agencies’ shareholders have reason to be pleased.

These businesses derive income in two forms. “Transactional" income flows from fees associated with rating new corporate debt issues; “relationship"-based income consists of ongoing charges for monitoring the ratings assigned. It’s a robust model in an industry with no serious competition beyond Fitch, S&P and Moody’s.

No wonder
Warren Buffett
cherished the stake he held in Moody’s for so long. Buffett also values his reputation and after he came under fire for defending Moody’s role in the global credit crisis, he gradually reduced his holding.

For the rating agencies, reputation has proved an over-rated trait. As the profit numbers show, their tainted image has not translated into less business.

In fact, many bond investors have defended the agencies’ calls. Yes, their pre-2007 structured finance analysis proved catastrophic, but their analysis of corporate credit – the agencies’ traditional line of work – has been broadly on the money.

The agencies’ advantage resides in their privileged access to corporate information, decades of data and decision making processes refined over years. While bond investors stress that it would be foolish to base investment decisions solely on credit ratings, disregarding their work would be equally unwise.

In recent months, however, it’s the rating agencies’ reviews of government credit that have roiled markets and sparked controversy.

After years of relative serenity, sovereign credit analysts have been forced to fold up their deckchairs and probe the fiscal health of governments that have assumed the burden of the private sectors’ over-leverage. Their unpalatable findings have put them on a collision course with politicians already keen to weaken agency influence.

Last week, S&P’s sovereign analysts made a bold move the vigilant bond market has failed to do: warn US politicians of the dangers associated with mismanaging the country’s ballooning deficit.

For those who have raised concerns about conflicts of interest, it may come as little surprise that S&P doesn’t get paid a cent for assigning and threatening to remove the AAA rating on the debt of the United States. The bulk of credit analysis on major sovereigns is conducted on an “unsolicited basis". Among the countries assessed for no fee are France, Germany, Japan and Australia.

But the ratings are embedded in the architecture of financial markets. Fund managers use them to set mandates while those who write the global banking rules defer to the agencies as to how much capital each bank should hold against a particular exposure.

With this in mind, S&P’s recent warning on Japan’s AA- rating could have dire consequences. With Japanese domestic savings expected to run down, foreign buyers are expected to play a greater role in Japan’s borrowings. But many will be blocked by their mandates from Japanese bonds if the ratings slip.

The rating agencies have been called many things. Irrelevant is not one of them.